16.1 – The follies of DCF Analysis

In this concluding chapter, we will discuss a few important topics that could significantly impact the way you make your investment decisions. In the previous chapter, we learnt about the intrinsic value calculation using the Discounted Cash Flow (DCF) analysis. The DCF method is probably one of the most reliable methods available to evaluate the intrinsic value of a company’s stock. However, the DCF method has its fair share of drawbacks which you need to be aware of. The DCF model is only as good as the assumptions which are fed to it. If the assumptions used are incorrect, the fair value and stock price computation could be skewed.

DCF requires us to forecast – To begin with, the DCF model requires us to predict the future cash flow and the business cycles. This is a challenge, let alone for a fundamental analyst but also for the top management of the company

Highly sensitive to the Terminal Growth rate – The DCF model is highly sensitive to the terminal growth rate. A small change in the terminal growth rate would lead to a large difference in the final output i.e. the per share value. For instance in the ARBL case, we have assumed 3.5% as the terminal growth rate. At 3.5%, the share price is Rs.368/- but if we change this to 4.0% (an increase of 50 basis points) the share price would change to Rs.394/-

Constant Updates – Once the model is built, the analyst needs to constantly modify and align the model with new data (quarterly and yearly data) that comes in. Both the inputs and the assumptions of the DCF model needs to be updated on a regular basis.

Long term focus – DCF is heavily focused on long term investing, and thus it does not offer anything to investors who have a short term focus. (i.e. 1 year investment horizon)

Also, the DCF model may make you miss out on unusual opportunities as the model are based on certain rigid parameters.

Having stated the above, the only way to overcome the drawbacks of the DCF Model is by being as conservative as possible while making the assumptions. Some guidelines for the conservative assumptions are –

FCF (Free Cash Flow) growth rate – The rate at which you grow the FCF year on year has to be around 20%. Companies can barely sustain growing their free cash flow beyond 20%. If a company is young and belongs to the high growth sector, then probably a little under 20% is justified, but no company deserves a FCF growth rate of over 20%

Number of years – This is a bit tricky, while longer the duration, the better it is. At the same time longer the duration, there would be more room for errors. I generally prefer to use a 10 year 2 stage DCF approach

2 stage DCF valuation – It is always a good practice to split the DCF analysis into 2 stages as demonstrated in the ARBL example in the previous chapter. As discussed ,In stage 1 I would grow the FCF at a certain rate, and in stage 2 I would grow the FCF at a rate lower than the one used in stage 1

Terminal Growth Rate – As I had mentioned earlier, the DCF model is highly sensitive to the terminal growth rate. Simple thumb rule here – keep it as low as possible. I personally prefer to keep it around 4% and never beyond it.

16.2 – Margin of Safety

Now, despite making some conservative assumptions things could still go wrong. How do you insulate yourself against that? This is where the concept of ‘Margin of Safety’ would arrive. The margin of safety thought process was popularized by Benjamin Graham in his seminal book titled “Intelligent Investor”. The ‘margin of safety’ simply suggests that an investor should buy stocks only when it is available at a discount to the estimated intrinsic value calculation. Following the Margin of Safety does not imply successful investments, but would provide a buffer for errors in calculation.

Here is how I exercise the ‘Margin of Safety’ principle in my own investment practice. Consider the case of Amara Raja Batteries Limited; the intrinsic value estimate was around Rs.368/- per share. Further we applied a 10% modeling error to create the intrinsic value band. The lower intrinsic value estimate was Rs.331/-. At Rs.331/- we are factoring in modeling errors. The Margin of Safety advocates us to further discount the intrinsic value. I usually like to discount the intrinsic value by another 30% at least.

But why should we discount it further? Aren’t we being extra conservative you may ask? Well, yes, but this is the only way you can insulate yourself from the bad assumptions and bad luck. Think about it, given all the fundamentals, if a stock looks attractive at Rs.100, then at Rs.70, you can be certain it is indeed a good bet! This is in fact what the savvy value investors always practice.

Going back to the case of ARBL –

Intrinsic value is Rs.368/-

Accounting for modeling errors @10% the lower intrinsic band value is Rs.331/-

Discounting it further by another 30%, in order to accommodate for the margin of safety, the intrinsic value would be around Rs.230/-

At 230/- I would be a buyer in this stock with great conviction

Of course, when quality stocks falls way below its intrinsic value they get picked up by value investors. Hence when the margin of safety is at play, you should consider buying it as soon as you can. As a long term investor, sweet deals like this (as in a quality stock trading below its intrinsic value) should not be missed.

Also, remember good stocks will be available at great discounts mostly in a bear market, when people are extremely pessimistic about stocks. So make sure you have sufficient cash during bear markets to go shopping!

16.3 – When to sell?

Throughout the module we have discussed about buying stocks. But what about selling? When do we book profits? For instance assume you bought ARBL at around Rs.250 per share. It is now trading close to Rs.730/- per share. This translates to an absolute return of 192%. A great rate of return by any yardstick (considering the return is generated in over a year’s time). So does that mean you actually sell out this stock and book a profit? Well the decision to sell depends on the disruption in investible grade attributes.

Disruption in investible grade attributes – Remember the decision to buy the stock does not stem from the price at which the stock trades. Meaning, we do not buy ARBL just because it has declined by 15%. We buy ARBL only because it qualifies through the rigor of the“investible grade attributes”. If a stock does not showcase investible grade attributes we do not buy. Therefore going by that logic, we hold on to stocks as long as the investible grade attributes stays intact.

The company can continue to showcase the same attributes for years together. The point is, as long as the attributes are intact, we stay invested in the stock. By virtue of these attributes the stock price naturally increases, thereby creating wealth for you. The moment these attributes shows signs of crumbling down, one can consider selling the stock.

16.4 – How many stocks in the portfolio?

The number of stocks that you need to own in your portfolio is often debated. While some say holding many stocks help you diversify risk, others say holding far fewer helps you take concentrated bets which can potentially reap great rewards. Here is what some of the legendary investors have advised when it comes to the number of stocks in your portfolio –

Seth Kalrman – 10 to 15 stocks

Warren Buffet – 5 to 10 stocks

Ben Graham – 10 to 30 stocks

John Keynes – 2 to 3 stocks

In my own personal portfolio, I have about 13 stocks and at no point I would be comfortable owning beyond 15 stocks. While it is hard to comment on what should be the minimum number of stocks, I do believe there is no point owning a large number of stocks in your portfolio. When I say large, I have a figure of over 20 in my mind.

16.5 – Final Conclusion

Over the last 16 chapters, we have learnt and discussed several topics related to the markets and fundamental analysis. Perhaps it is now the right time to wrap up and leave you with a few last points that I think are worth remembering –

Be reasonable – Markets are volatile; it is the nature of the beast. However if you have the patience to stay put, markets can reward you fairly well. When I say “reward you fairly well” I have a CAGR of about 15-18% in mind. I personally think this is a fairly decent and realistic expectation. Please don’t be swayed by abnormal returns like 50- 100% in the short term, even if it is achievable it may not be sustainable

Long term approach – I have discussed this topic in chapter 2 as to why investors need to have a long term approach. Remember, money compounds faster the longer you stay invested

Look for investible grade attributes – Look for stocks that display investible grade attributes and stay invested in them as long as these attributes last. Book profits when you think the company no longer has these attributes

Respect Qualitative Research – Character is more important than numbers. Always look at investing in companies whose promoters exhibit good character

Cut the noise, apply the checklist – No matter how much the analyst on TV/newspaper brags about a certain company don’t fall prey to it. You have a checklist, just apply the same to see if it makes any sense

Respect the margin of safety – As this literally works like a safety net against bad luck

IPO’s – Avoid buying into IPOs. IPOs are usually overpriced. However if you were compelled to buy into an IPO then analyze the IPO in the same 3 stage equity research methodology

Really wonderful .But I feel rather bookish and exhausting and at the end may find most blue chips over priced.Only at bear market bottom may one be able to buy reasonably priced shares. May be P/E ratio and comparing with peers can help.
Retail investors may not find it practicable and buying in declines and in parts ‘quality’ stocks may be more possible.
But then what is quality!

Kindly note I enjoyed reading and really touched by your covering financial management in a few pages.

If you could kindly highlight why you thought it was bookish it would help. In fact one of the objectives of Varsity was to make sure the content is not bookish and in fact be very practical. So your suggestions will really help us deliver better content. Thanks.

Thanks for uploading the lessons. Walking us through an example was really helpful. I plan to analyze few stocks based on these lessons in next few days.
I was wondering, wouldn’t institutional investor be the first to do fundamental analysis of a company? And by the time a retail investor start evaluating a stock, wouldn’t a good company will already get overpriced by institutional investors by then?

Ajit – The institutional investors have a major disadvantage. Their size! Contrary to the popular belief, by the time they identify a stock to invest, it may actually be a bit late. I have seen this happening over and over again in the markets. Would suggest you read this book ‘One up on Wall Street’ by Peter Lynch. In the book Peter Lynch clearly discusses how advantageous it is to be a retain investor in terms of spotting good investing opportunities.

FA is a different thought process all together. The focus in only on business, corporate governance, sustainable moats, and numbers. Everything else is secondary. If you look at quality stocks that have generated wealth to shareholders they were all undervalued and lacked market interest before they really too off. Which also means in the initial days volumes were really low in these counters. So I suggest you stay focused on the business and leave aside volumes and other other such parameters.

Hi Karthik,
I happened to come across this. You have done an excellent job here by explaining Fundamental Analysis in the most pratical manner., worth implementing. Looking forward to make some long term ‘wealth-creating’ investments using these. 🙂
Once again., appreciating the wonderful effort from your side.
Regards,
Mukesh

Thanks a lot.I cannot belive its FREE…& so much information is available.
Since inception ZERODHA always have something innovative to offer.
Looking forward for F&O MODULES & ZERODHA Pi………and lot more
Thank You again.

These chapters are well written, with a proper examples, when and where required. The language used, or the approach used while writing these chapters is more friendly, such that we are immediately able to connect ourselves with it. I would like to thank you(KARTHIK RANGAPPA) for writing these chapters, and to zerodha (the team and Mr. Nitin Kamath) for taking such initiative for us.
Reading these chapters helped me a lot in understanding the basics of the share market, which includes overview of the market, technical analysis, and fundamental analysis, similarly I understood how the companies are formed, which parameters are important to rank or scale the company, and how one (CEO, managers) should look after his or her company such that their investors shall not worry much.
Thanks again for the initiative.
And I hope we will soon be reading the remaining chapters.

Thanks. Stoploss is mainly from the perspective of validating the moats based on which you have invested. In other words, as long as your investment reasons are valid you continue to stay invested, else you exit.

Yes I found it. karthik i clearly understood fundamental analysis was helpful for long term investments.And I Knew technical analysis was for short term trading in this we were using Chart patterns , candlestick patterns and technical indicators. Can U plz suggest me , Should we use all are these patterns are needed or any one of them(i.e., charts/candlesticks/indicators) is enough for short term trading.

Well the returns and risk go hand in hand. Higher the risk you take higher is the possibility of a good return. When you have 1 stock in your portfolio you are taking maximum risk…therefore maximum return. However when you 5 you are spreading your risk and therefore lowering your risk. De-risking is good, and I personally believe a 12 – 15 stock diversified portfolio is fair. Higher the number of stocks, you are not only re-riskinng a lot, but like you said managing and tracking them also becomes an issue.

Overweight = when you highly bullish on the stock and you purchase more of the stock in your portfolio
Underweight = When you are not so bullish (note this is different from being bearish) but still believe you are reluctant to sell it
Neutral = When you neither feel bullish or bearish about the stock

Very well written, nicely structured article without using too many financial jargon. I wish you have would have little more detailed the discussion on ideal portfolio in terms of number of stocks / sectors, diversification need, max % of fund in a particular stock etc. However overall an excellent job. Please make the articles available in a single pdf document, if feasible.

The image which i showed you previously (3 white soldiers).It was supposed to go up today as it was bullish. but today it went down. The volume was ok,And i hope the indicators where also fine. why it went down today?…i have attached the pattern image and the indicators image.Thank u .

1. you have advised to look for prior trend. how long should we consider for this. For example,if p1 & p2 forms bullish engulf.can i look for downtrend of 5days or 14days or ???…..which would be sufficient to analyse this.

2. First we check 3 to 4 days for a recognizable pattern,then we go to other steps.But u have Given a lookback period of 6months to 1year. And upto two year while analysing S&R.

For rsi look back period is 14days ..etc
then where to use this lookback period of 6 months to 1year ?..

if i purchase amibroker, then i want to find out the list of companies which EPS is higher than 20 and PE is less than 10 in BSE and NSE both. so which data provider is useful to me. which data provided provide NSE & BSE both data. whenever i know GLOBAL DATA FEED only provide NSE(F&O) not NSE (CASH) & BSE. So any other data provider which can i use in amibroker who provide NSE & BSE (F&O & CASH BOTH) Please guide me sir……….. thanks

the intrinsic value of torrent pharma is 529- 646 . But it is currently priced at 1200. But the p/e ratio is 11 which may be considered good and the company is doing well . But the price is considered over priced according to calculations . Is it a good option to buy it now or look for another option ? Is a software that can calculate the intrinsic values ?

PE and DCF valuations are two different valuation techniques. However, as you may have observed, the 2 stage DCF has many input variables, any slight variation can lead to erroneous output. I’d suggest you double check all these input variables.

According to ratio calculations Pageind stock looks expensive.
P/BV-40
P/E-60
P/S-10
I bought it
around 11700 now it has fallen more.
So according to qualitative aspects I should hold it or is it overpriced and sell it?

Once again, thanks for the modules Karthik!
I would like to know usually how many days a company takes to release their annual report after they have made an announcement of the financials? for eg. this year, Infosys has announced its financial results on 15th April, usually how many days after that the company takes to release the Annual Report?

It’s Chad again.. I finished reading the entire series and I am feeling much much more empowered than before. As I had also said in my previous comments, I cannot thank you enough for your single handed effort.
And as I had said, here is my consolidated list of questions on all chapters. I have tried to find most of the questions in the comments first but I may have missed any. In that case, please point me there.
So,
1. How does it affect the P/L statement and cash flow statement when an asset is written off?
2. When the business is export based, how to take rupee depreciation into consideration?
3. When the parent company is Indian and all its subsidiaries are overseas, even then the stand alone results do not matter?
4. Isn’t lower the inventory the better? Is there any ratio of inventory to revenue which justifies it?
5. Shouldn’t inflation be taken into consideration while calculating average FCF or for that matter any YoY average values?
6. How to determine discounting rate? Is the discount rate same as inflation or is it the opportunity cost for other safe investment means? Does it vary across industry/sector?
7. When do dividends matter while calculating FCF or making DCF? (In the days when price is much more than the face value and where dividends are offered on face value, generally cash flows from dividends are meagre. But sometimes, small and medium core companies with large promotor holding try to offer dividends making it a function of number of shares and not the actual profit. How to take that into account?)
8. While calculating FCF why to consider only OCF? Why not cash flow from investing activities too? What if the net cash flow is negative for years? How to calculate FCF then?
I am immensely grateful for your time which you might take out to answer these questions.

I’m glad you liked the contents Chad. Here you go, in the same sequence –

1) When an asset is written off the direct impact would be on depreciation value, which would decrease in P&L, and therefore increase the bottom line. In cashflow, depreciation is added back to net profits to get the cash flow from operations….so since the value would reduce, the CF from operations would go down a tad bit.

2) Usually, companies dealing in forex would hedge their currency exposure so minimize the impact of currency fluctuation.

3) Nope, always stick to consolidated

4) Lower inventory can be tricky – isit low because there is demand for the products, therefore company is not pushing, or isit low because its getting sold like hot cakes? Obviously, the latter is desirable. Inventory number of days and inventory turnover ratio will help you answer these questions.

5) We bring back FCF to present value by discounting, this takes care of inflation

6) Varies across industries….and across the size of a company. For example for a company like infy, i’d be happy to take 10-11% discounting rate…but for a smaller company, I would expect a higher return. The rate that you consider comes from your personal valuation experience.

7) Dividends do not play a role in DCF calculation

8) For any company cash flow from operations is what matters – after all this is what they are supposed to do i.e make money by running a profitable operations. Cash flow from other activities are incidental to the business and cannot be forecasted. Hence we stay conservative and take only the cashflow from operations. If the net cash flow is negative, then it just means that the company is operationally weak…you should not even considered investing in such companies unless you believe the turnover is around the corner.

This is amazing Karthik. Thanks a lot for taking your time out once again. BTW, I researched one of the references you had quoted (Prof. Dr. Aswath Damodaran) and I found on his website some very valuable data which can help determine the complex unknown factors such as industry wide discounting rate or overall cost of capital required for DCF modelling.
I hope it might be useful to other fellow investors as well visiting this site.http://people.stern.nyu.edu/adamodar/New_Home_Page/datacurrent.html

Hi sir,
Recently i read varsity module of Fundamental Analysis part.
I am very much impressed the way you guys have developed it…its just awesome…special credits to you Karthik Sir.
My request is to send me the excel sheet that author claims to have made for the Fundamental Analysis purpose.
At the end of DCF chapter (5.2 module), Author claims that he has made a excel with formulas so that we can download it and use it for practice. but i could not find the excel sheet there sir.

really useful article sir…thanks….do the companies consider same method while giving bonus shares or in stock split? when company split the share does it match undervalue( or right value) of that stock with that price ? isnt it good buy opportunity if other conditions(financial,P/L ) are okay?

wHAT MY QUESTION IS THAT?
IN chapter 12 of FA 12.4 IN THE TABLE YOU written GPM> 20% ROE>25% ? how did you come up with these conclusions ? Are these numbers of these ratios preferred safe investment like that? if so why?
I mean why did n’t YOU choose as ROE > 19% GPM > 15%? thats my question
I do not have any problem in calculating these ratios.

Reading this module was very satisfying. Concepts explained in simple manner. This is my third module. Keep the good work going. One question. We didn’t cover one of the popular valuation ratio – PEG. According to you how important is it.

Dear Sir
I am okay with the growth concept which can be arrived at by using CAGR .
But how did you estimate the required rate of return ?
I have read about the CAPM model to predict the required rate.
All the factors in CAPM i.e RF , Beta can be however known .
Can you please give a real life situation of calculating Market risk premium , thereby Required rate of return?
Thanks in advance

I tend to keep the model conservative, where the cost of capital (WACC) is higher and the growth rate is lower. There is no rigid number here…apply the numbers based on the company and the industry it belongs to.

Hi Karthik, From few days, I have been reading Economic times Markets Page, and I find stories of people who have become a millionaire by picking stocks early which then became a multibagger giving skyrocketing returns.

My question is how to pick a multi-bagger stock which is not on the radar of smart money yet. I mean, out of 4000 stocks listed on NSE there should be a system in place to evaluate and eliminate and come to a one or few names that could be further evaluated. Checking each and every stock does not seem to be a practical idea.
Also, One factor that was common was to identify a strong and dedicated management. Others were futuristic business, scalability, etc. The problems with these kinds of factors are: They are subjective, not easily translated to numbers.

Does this call for a new chapter for Varsity — Identifying Multi-baggers.

I do know that they are different indices. My question is why nifty50 value is smaller than nifty bank. Nifty bank has 12 bank stocks and nifty50 has 51 stocks. How can the value of nifty50 has smaller value than niftybank considering the fact that usually more number of stocks included in an indice should have more value technically right?

Index is a portfolio. Banks have rallied very well over the years and so have their share prices. The effect of the increase in share price is captured very well on a portfolio of 12 stocks versus a portfolio of 51 stocks. In other words, a portfolio with a lesser number of stocks tends to out perform/underperform a portfolio with more number of stocks.

Just did a study on Cochin Shipyard Ltd since its going to be listed in the market. Did a study of Annual Reports of CSL from Mar-12 to Mar-16 and as per the analysis the DCF price band buy level is coming around between Rs.98 to 80. In the mean while they have fixed the price band from Rs.422 – Rs.432/-

I will be sending the working file at your email id. Please do check it whether my calculations are right and come out with your opinion. For me I won’t buy the Cochin Shipyard Ltd IPO since its expensive. For me the buy price is between Rs.98 to 80.

Regards,

Sonjoe Joseph.
(There is no scope of file attachment here do reconsider it)

Sonjoe, I’m really sorry but I’m not sure if I can go through the excel sheet. However, my guess is that you may have not really taken a relevant growth rate for the cashflows. Please do double check all the variables.

In the case of ARBL Example you have taken the maximum growth rate as 18% and minimum growth rate as 10%. Further u have told that if its a mature company then u will take the maximum growth rate as 15% and minimum growth rate as 10%. The company under consideration “Cochin Shipyard Ltd” has just released the IPO. While analyzing the annual report just got the following figures:-

As per the above figures for the calculation of DCF Model what should be the maximum and minimum growth rate? Among the 6 CAGR Growth rates above which one should i take for the maximum and minimum growth rate.

The growth rates are not so impressive (assuming the numbers are correct here). Anyway, when you assume forward looking rates (such as the growth rate), you will have to consider the business prospects of the company. For this, you will have to see what the management has to say…based on this, I’d would assign the growth rates.

In the Cochin Shipyard Ltd Annual Report 2015-16 under “Management Discussion and Analysis Report” its said that ” The Indian Defense Shipbuilding market looked promising with the published reports indicating a growth of 10% CAGR in Navy outlay during the period 2000-2014. As per published report the estimated defense sector opportunity in shipbuilding in the next 10 years is above `4,00,000 crores”

So under this circumstances can i give a maximum growth rate is 10% and minimum growth rate as 5 % in which the share price good buy will be around Rs.61 to 50. Even if i give an extreme value say maximum growth grate 25% and minimum 15% then the buy price will be around Rs.149 to 122 which will be near to the present book value of Cochin Shipyard which is Rs.153. Even the sales per share is Rs.186/-

as you said as company matures it doesn’t grow much so we take 3 to 4% growth after 10 years. For companies like TCS Infosys and other very good companies which are very old and as per your defination they are mature, what percentage of growth for initial 10 years we can take for these companies. how can we apply DCF model for analysis of INTRINSIC VALUE of these companies at present time.